Overdraft Protection: What It Is & How to Avoid Fees

Richie Bernardo, Senior Writer • Mar 19, 2015

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No one is perfect, and everyone from time to time will overdraw his or her checking account. Maybe you miscalculated your balance or forgot to deposit money. It happens. But the cost of an occasional blunder can add up because most banks and credit unions charge substantial fees of $35 or more whenever you exceed your account balance — not to mention the additional embarrassment and headaches of bouncing a check or electronic payment.

You can, of course, prevent overdrafts by carefully budgeting and balancing your checkbook. But there’s another alternative that can help you prevent such mishaps and their accompanying fees. Banks and credit unions offer a service called overdraft protection that allows you to cover transactions if your checking account lacks adequate funds. Read on to learn how overdraft protection works, how much it costs, and what happens if you don’t have it.

How Does Overdraft Protection Work?

Whenever you attempt a transaction for more than your account balance, your bank or credit union has two options: (1) it may cover your overdraft — which means your account balance will go below zero — and charge you an overdraft fee or (2) it may reject, or “bounce,” the transaction, which means you may incur a nonsufficient funds (NSF) fee as well as, potentially, a fee from a business that wasn’t paid. If you do not repay these fees and your account stays negative for more than a few days, you may incur additional “sustained” overdraft fees.

That’s where overdraft protection comes in handy.

With overdraft protection, your checking account is linked to another account from the same institution so there’s another source of funds when your checking account is depleted. Every time you overdraw your account, your bank or credit union will pull funds from that backup source to cover the shortfall. You’ll pay a fee when overdraft protection kicks in, but it will be lower than the fee you would pay for an overdraft.

Types & Costs of Overdraft Protection

Most banks allow you to fund overdraft protection from a variety of accounts, and we’ll give you a brief overview of your options — as well as the corresponding costs — below.

Overdraft Protection Plan

Description

Sample Cost*

Linked Deposit Account

This can be a checking or savings account you have with the same financial institution.

$5 – $10 Transfer Fee

Overdraft Line of Credit

This is a loan offered by your bank or credit union specifically for covering overdrafts.

All of these options will provide you protection against overdrafts. You can choose the one that best fits your finances:

Linked Deposit Account: This form of overdraft protection links your checking account with another checking or savings account that’s at the same institution and in your name. You will pay a flat fee — between $5 and $10 — for every transfer made to your checking account from the backup source. Often, this fee is charged only once per day or your institution will transfer funds in larger increments (say, $100 at a time) so that you avoid paying multiple overdraft fees. This is by far the cheapest option among the three overdraft protection plans available.

As long as sufficient funds are available in the backup account, your institution guarantees your check or purchase will clear. Keep in mind that transfers from savings accounts (including those for overdraft protection) are limited by law to a monthly total of six. If you exceed that limit, you risk losing privileges on that account or having your savings account converted to a different type such as regular checking.

Overdraft Line of Credit: Offered by banks and credit unions, an overdraft line of credit is essentially a loan. You will pay interest — and possibly an annual fee or a transfer fee, depending on the institution — on until you pay off the balance of the loan.

Like any other loan, an overdraft line of credit will be subject to a credit limit, depending on the institution as well as their assessment of your credit and other factors. The amount you borrow to cover the overdraft can be repaid gradually over time, as long as you make the minimum monthly payment under the terms of the line of credit.

Linked Credit Card: By linking your checking account to your credit card, overdraft protection is treated like a cash advance against your credit limit. Depending on your issuer, you may have to pay a transfer fee, a cash advance fee, and a higher interest rate than on normal credit card purchases.

Unless you have a grace period on cash advances, the transaction will begin to accrue interest as soon as it’s charged. If you choose this option, make sure to check if your issuer offers a grace period, and pay back the balance as soon as possible to avoid racking up unsustainable debt.

Do I Need Overdraft Protection?

If you frequently overdraw your checking account, then you definitely should consider overdraft protection. Overdraft fees can add up quickly, and if you bounce enough checks, your name could end up in a credit reporting agency used by banks and credit unions, such as ChexSystems, Early Warning Services, and TeleCheck. In that case, your institution can close your checking account, and you’ll likely have trouble opening a new one. Some businesses may refuse to accept your checks.

Before enrolling in an overdraft protection program, however, make sure you read the fine print and ask your institution about its specific terms, conditions, fee structures, and other related policies. Of course, responsible budgeting and account management is always the better alternative, but setting up overdraft protection will give you an additional margin for error.

Other Ways to Avoid Overdraft Fees

If you prefer not to enroll in an overdraft protection program, there are other ways you can avoid racking up costly overdraft penalties. A few of them include the following:

Learn to Budget Well: Although easier said than done — as this option requires skill-building — good money and account management habits is hands down the cheapest and most effective way to avoid fees. Keeping tabs on your transactions — by maintaining a check register and monitoring your checking account online — can go a long way and save you potentially hundreds of dollars a year on overdraft fees if you’re constantly depleting your checking account.

Get a Prepaid Card: Prepaid cards function like traditional checking accounts without the ability to write paper checks. That already eliminates the possibility of bouncing one. If you don’t have enough money in your prepaid account, transactions will simply be denied.

Know the Rules: When you open a checking account at a bank or credit union, you’ll be asked whether you’d like your overdrafts on one-time debit card transactions and ATM withdrawals to be paid for in exchange for an overdraft fee. According to Federal Reserve regulation, you are not obligated or required to have this option on your account (except for recurring payments or transfers and paper checks you write). You can simply deny this offer, and your financial institution will decline transactions that would otherwise put your account in the hole. In this case, you will not be charged any fees.

Image: maxuser/Shutterstock

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